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The European debt crisis involves a type of investment long considered to be one of the soundest available -- government bonds issued by European countries. It is a situation which has taken politicians by surprise as well, as can be seen by existing regulations regarding the assessment of risk posed by sovereign bond investments. When determining how much equity capital banks need as a buffer, the risk of financial loss associated with government bonds is considered to be zero. In the middle of the year, many banks were already forced to write off 21 percent of their Greek bonds due to the impending debt reduction, known as a "haircut." That, though, likely won't be enough. Greek bonds may soon lose half their value -- if not more. German financial institutions would likely be able to absorb such losses. The country's 13 largest banks have reduced their Greece-related risks to €5.6 billion. But what if other European countries are affected by the turmoil? Currently, Italian and Portuguese government bonds are only being traded at a steep discount. If Greece were to default on its loans, the market value of these bonds would plummet even further. US investment bank JP Morgan suggests a scenario in which Greek bonds have to be written down by 60 percent, Portuguese and Irish bonds by 40 percent and Italian and Spanish bonds by 20 percent on bank balance sheets. Due to these write downs alone, JP Morgan says that European banks require an extra €54 billion. Analysts at Morgan Stanley even recommend up to €150 billion more in capital.

To recap: In July, European leaders crafted the fund (technically, the European Financial Stability Facility or EFSF) as a $588 billion rescue fund to prop up Greece and other nations that are bankrupt in reality — if not in public. Of course, it isn’t just the governments which will need rescuing. It is also all the other institutions that made loans to Greece & Co. When (not if) the default happens, a lot of already shaky banks will have much more debt than they do assets. Investors and depositors will then act on the fact that those institutions are not a good place to keep their money. The banks that loaned to the banks that loaned to Greece will also have more debt and people will worry about those banks. This will worry the banks that loaned to the banks that loaned to the banks to fund the mess that Greece built. The EFSF is supposed to be that something. The theory is that it will do this by providing money to a lot of those governments and institutions